To Roth or Not to Roth? That Is the Tax-Planning Question

With the tax-filing deadline tomorrow, you’ve likely already filed your income taxes for 2017. Hopefully you planned well and you have a nice refund coming your way.

I know this might seem odd coming from a legendary cheapskate like myself, but if you have decent-sized refund coming your way, don’t feel compelled to save and invest all of it. You can splurge at least a little on something frivolous or fun.

If nothing else, take your family to a nice steakhouse. You have to enjoy your money from time to time to remind yourself why you’re working so hard to make it.

But once you’ve had your fun, it’s time to start planning for 2018.

Along those lines, take a look at your current retirement plan elections and specifically the split between traditional tax-deferred 401(k) contributions and Roth contributions. Because if it’s been a few years since you’ve looked at it, your old election might not longer make a lot of sense.

I met a friend of mine back in December at our favorite watering hole for a pitcher of Shiner Bock and a game of Golden Tee. (Don’t judge me. Golden Tee is therapeutic and a welcome distraction from the market.) Somewhere around the ninth hole, he commented that he had maxed out his Roth 401(k) for the year and that he was proud of himself.

Well, he should be proud of himself. That’s an accomplishment. But given that he and his wife together earn enough to place them in the 39.6% tax bracket in 2017 (32% in 2018), it’s not the best financial move. He should have maxed out a Traditional 401(k) rather than a Roth.

Standard financial advice would tell you that the Roth is always a better option. But that simply isn’t true. Yes, the Roth can be better, and for many investors it probably is. But if you’re in a high tax bracket, it’s a terrible idea.

In a Roth 401(k) you get no tax deduction in the year you contribute, but your investments grow tax free, and you’ll never pay taxes when you withdraw the money in retirement. That’s fantastic. And if you’re in one of the lower tax brackets (say, 12% or lower), the current-year deduction, while nice, isn’t really worth all that much.

But what if you’re paying 32% or more? The 401(k) tax break is saving you some serious money.

This is my rule of thumb: If you’re young, fresh out of school, or have a modest income, you’re probably better off going with the Roth option. You’ll likely be earning more in the future (and thus be in a higher bracket) than you are today. So, it’s better to save the tax break for then.

If you’re further along in your career and earn a high income, go with the Traditional 401(k). A bird in hand is worth two in the bush. The tax break is useful to you today, whereas the benefit of the Roth won’t be noticed for decades, and by then it’s entirely possible that Congress will have moved the goalposts on you by changing the tax laws.

We don’t know if the government will honor its promises in the future. But we do know what rates look like today and the potential tax savings of stuffing cash into a Traditional 401(k).

Putting specific numbers to it, at the 22% income tax bracket (income of $38,701 to $82,500 for individuals and $77,401 to $165,000 for married couples filing jointly) I would personally start favoring traditional contributions over Roth contributions. A 22% tax break today is real money.

If you’re undecided or feel like you’re somewhere in the middle, you can always split the difference, putting a slice of your paycheck into both the Traditional and Roth 401(k) options.

Oh, and by the way. We’re now more that a quarter of the way through 2018. So if you’re going to max out your 401(k) plan for the year at $18,500, you should have contributed close to $5,000 by now. If you haven’t… get on it while you still have time!